The term “shadow banking” irks some, who believe it’s a pejorative term that undermines capital market professionals working outside the traditional parameters of the sector. Indeed, they argue that many operators in this sector are more transparent than banks, who retain opaque and complex practices. They prefer terms such as “market-based finance”, or “non-bank lenders”.

Call it what you will, shadow banking is big business. The FSB believes this murky, misunderstood periphery makes up 13% of global financial assets. That’s $45tn in assets. China is the global epicentre of all this, a place where unregulated lenders have filled the vacuum left by established banks who are unwilling (or unable) to extend credit to consumers and businesses. The country contributed $7tn, or 15.5% of the global total, although the authorities’ subsequent crack down on shadow banking is yet to feed into the data.

Much is at stake. Shadow banking poses risks to the global financial system, which could be masked for long periods by low volatility. Colm Kelleher, president of Morgan Stanley, recently observed that shadow banks are increasingly acting as middlemen between buyers and sellers, with large banks hampered by regulations that make it harder for them to hold trading assets and make markets. And new risks are emerging all the time. Take, for example, the crypto craze. The FT’s Izabella Kaminska has argued that, “The crypto currency phenomenon can be seen, therefore, as shadow banking moving to the next stage of private money creation and liquidity management.”

What’s certain is that the stability of the global financial system depends on regulatory oversight, which itself depends on good data. One cannot happen without the other, and it’s good to see that countries like China and Luxembourg are opening up their data on shadow banking and providing policymakers with greater visibility. Having said this, question marks remain about the real size of the shadow banking economy. By narrowing the definition of shadow banking in recent years, the FSB has created a category that is easier to define, monitor and regulate. But the real shadow banks are harder to spot, and even harder to marshal.

Concerns persist, but to suggest that shadow banking poses an existential threat to the global financial system would be hyperbolic. By diversifying the composition of global lending and spreading the risk around, shadow banking might actually reduce the chances of a “too big to fail” scenario being played out as per the global financial crisis of 2007/8. Conversely, it could also introduce new levels of complexity that make it harder for policymakers to safeguard stability and fight fires when they break out. The jury’s out.

Ultimately, shadow banking exists for a reason. It performs a series of valuable economic activities, extending credit and liquidity, albeit in an opaque, fragmented kind of way. Shadow banking helps power the real economy, driving wealth and employment creation. When banks fail to extend loans to credit-worthy businesses that lack the necessary collateral, business owners have no choice but to go somewhere else for funding. With improvements to credit risk scoring powered by new technologies – such as AI and biometrics – demand for shadow banking should decrease over time. For now, it’s here to stay. Who are we to say that’s a bad thing?

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